The previous two parts argued that by combining schemes for
privatizing state-owned enterprises with programmes for swapping
external debt into equity in these entities, the debtor country can
foster greater economic efficiency, stimulate new capital inflows
and capital formation parallel to external debt burden relief. The
micro level effects of debt-equity conversions are enhanced by the
macro implications for the indebted country, recipient of the
equity investment. International experience evidence heterogeneity
in the national welfare implications of DESs schemes.
3.1 Debt-Equity Swap Mechanism
DESs schemes are said to be a new market approach to debt
adjustment initially originated as a plausible debt crisis solution
in the Latin American countries. Types of swaps differ according to
the guiding motives of the parties involved. Banks swap debt for
portfolio reasons; sell debt at a discount for cash to MNCs who
then swap it for the indebted countryвs currency at an implicitly
preferential exchange rate and thereafter invest the cash in direct
or portfolio assets in the debtor country; banks may sell the debt
to local residents of the debtor country who may then swap it at an
implicitly preferential exchange rate for local equity investment
or sometimes for their own unrestricted use (see G. McKenzie and S.
Thomas). This way debt may be swapped several times as banks and
final investors structure their portfolios to reach a particular
desired allocation. DESs entail diverse number of participants each
of them pursuing own objectives - foreign creditors (commercial
banks), foreign and domestic investors, the government of the
indebted country and number of complex operations.
DES schemes cover the privatization program framework, legal and
regulatory framework, debt instruments that can be converted,
eligible investors and criteria for local asset eligibility,
discount involved in the conversion (and the fee if charged),
dividend remittances and capital repatriation, requirements with
regard to additional investment, accounting and tax issues involved
in converting debt into equity. These diverse transaction steps
impose certain advantages for all participants. An implicit subsidy
is captured by the foreign investor who buys the debt notes at
discount in the international secondary markets. The extent to
which this market discount is gained by the debtor depends on the
value at which this note is recognized by the debtor's central
bank. As accessible data from countries that have implemented DESs
suggest that most of this discount is captured by the foreign
investor or creditors.
As a debt-capitalization transaction DESs can take a variety of
forms. These many variations depend on the countryвs regulations
governing the operations of the schemes.
The essential advantages and disadvantages of debt conversion
schemes may be understood by making an important distinction - the
present analysis is made on the basis of the conventional
debt-equity-swap scheme. An investor buys in the international
financial markets at discount country's current obligations to
commercial banks which obligations are in the form of $-denominated
bonds issued by the indebted country. These bonds are either
directly converted into equity (direct or portfolio investment) or
exchanged for local currency (the central bank of the debtor
country exchange these bonds at face value, multiplied by the
exchange rate). The local currency cash is invested in the proposed
investment in the country that has been approved by the country's
government. At the end of the transaction, everybody seems to be
better off: the bank has sold a risky asset, even though at a
discount, the final investor has acquired a local asset at a
discounted price, and the debtor country government has retired
some of its external debt outstanding. The case when there is no
requirement for the debt-local currency to be invested in the
debtor county will not be considered. For Bulgaria as an indebted
country the mechanism is beneficial since it provides for the
cancellation of the debt swapped at its full $-denominated face
value. If an auction-base system is used for swapping debt holdings
the debtor country may capture revenues from fees.
3.2 The Determinants of The Size of The
Market
The volume of DESs transactions for the debtor country is
determined by supply and demand in the secondary market. It is
often said that the secondary market is very thin in term of its
trading volume. Other features of the market are: high
concentration of buyers and sellers; relatively long lag for deal
completion (typically 2 month); high degree of heterogeneity and
the absence of firm quotas (see K. Dezseri and J. Marcelle).
The theory of pricing behaviour in the secondary market for the
loans of the indebted country suggests that the determinants of the
portfolio value include: economic performance measured by the
standard indicators ( real economic growth, inflation, trade and
account balances) and debt servicing capacity measures (ratios of
outstanding debt to GNP, exports, international reserves, imports).
Econometric testing of the determinants of the pricing of the LDCs
debt was made by Laney , including both economic, political and
sociostructural explanatory variables. His main result proved that
secondary market prices are mainly determined by economic forces
(see Laney).
On this basis the economic forces-driven behaviour of the
secondary market nevertheless rather unpredictable reflects the
interplay of supply and demand changes. It was pointed out above in
this paper that the demand for debt trading in the secondary market
is driven by the motives of the banks for changing their portfolios
priorities, foreign investorsв expectations for the profitability
of an equity investment in the debtor country and the supply of
viable projects.
There is empirical evidence that in the secondary market demand
mostly determines the volume of DES transactions. Final demand can
increase as more equity investment projects become attractive to
external investors. This connection requires a supply of a set of
attractive long-term investment opportunities offered to investors
who are interested in purchasing countryвs debt.
The supply of outstanding debt in the secondary market by the
creditor banks depends crucially on the regulatory environment in
the countries where the swapping banks are domicile and banksв
capital structure strategy. Tax and accounting issues in the
creditor banksв countries shape banks decision for managing their
exposure to debtor countries with servicing difficulties. Creditor
banks face several alternatives: they can continue to restructure
credits; sell debt instruments at a discount in the secondary
market; convert the credit into equity investment in the debtor
country.
The attractiveness of market-based debt stock reduction
operations through debt-equity swaps is affected by the discount
that is captured by the buyer. As Basile argues this market-based
discount reflects the market valuation of the debt assets of the
indebted country and governs the supply and demand of debt
obligations (see An. Basile, 1992). This way, raising
secondary-market prices as a result of a deal settlement reduces
the percent discount. This discount over the face value of the
obligations vary from country to country depending primarily on the
creditworthiness of the country (this discount is very high for
countries with high credit risk).
The securitization of debtor country's external obligations
helps financial institutions to realign their foreign portfolio
holdings to their risk preferences. Some of Bulgaria's risk-averse
creditors prefer to receive their obligations in cash (mainly by
buy-back) while others (Austrian and German banks) have shown
considerable interest in debt-equity-swaps and rather insignificant
in debt buy-backs. These creditors are traditional Bulgaria's
business partners and they are optimistic about country's economic
recovery. Austrian banks and firms are particularly interested in
the Bulgarian economy since many enterprises in Bulgaria were
established with Austrian capital and credits.
Finally, the selected response from the banks will depend on the
profitability that each of the policy instruments (sales of assets,
debt-debt swap to focus to change the ownership of the debt
holdings, further bargaining with the debtor country).
By exchanging the foreign debt obligations, acquired at a market
discount over the face value at the official exchange rate, the
purchaser of the external debt can obtain local assets at a much
lower cost and advantageous position. Basile views the inefficient
nature of capital markets that allows foreign investors and an
indebted country to gain from these transactions at the expense of
the creditor banks. The secondary markets of debt obligations
generate these negative externalities imposed on creditors which
price the $-loans of the indebted country bellow the present value
of the expected payments of principal and interest.
3.3. Impact Assessment
In managing countryвs debt problem there are short-term and
long-term considerations. The long term measures include all these
that induce growth, investment, promote export-oriented development
and restructuring of the economy. Measures that are concerning
balance of payments equilibrium are of a more short-term character.
Multi-year restructuring, reduction of interest rates and spreads
which help to maintain levels of import and debt service are
example of these (see K. Dezseri and J. Marcelle). A comprehensive
impact assessment needs also to include medium term time
horizon.
Evaluation of DESs implications on the debtor country economy
should weight the gains these transactions will raise as opposed to
the costs which countryвs external indebtedness imposes on the
economy. The countryвs debt overhang has deteriorated the terms of
trade and investment financing. K. Dezseri and J. Marcelle give an
indication of the economic costs of indebtedness for the troubled
country: debt service payments in absolute and relative terms
remains high; decline in GDP per capita growth levels; high
inflation because of low growth; declining levels of investment;
rising levels of unemployment. The situation can be greatly
improved upon debt and debt service reduction agreement, including
debt-equity schemes.
It is not only the economic theory that is not to enthusiastic
about the "all-solving" effect of DESs but also the empirical data
on the volume of swap transactions relative to the size of
outstanding debt. There are advantages and disadvantages that are
effected by debt-equity financing.
Domestic aspects
The macroeconomic implications of DESs can be understand in
terms of the nature of such swap. The exchange of external debt in
the debtor country creates new equity. The problem is that the
Bulgarian government has to finance the repurchase of its debt in
some way, either by issuing domestic debt or printing money. DESs
lead to some difficulties related to the adverse impact of the
increase of local money supply. Therefore providing in cash local
currency in exchange for the external loans owed now by the
investor, inflation will rise. To avoid this effect the local money
supply has to be held constant which finally implies "loan currency
substitution" through the DESs (G. Franke, 1992). The solution can
be found in borrowing the money for debt conversion from local
agents and give the investor a long-term local-currency loan. A
monitoring of the amount converted can be achieved by introducing
by the central bank a monthly auction quota of conversion rights as
was the case of Chile. In the case of Bulgaria this inflationary
impact can be neutralized if debt-equity transactions employ use of
government bad-loan obligations, particularly those denominated in
US dollars, when converting the external debt obligations into
internal equity. Foreign investors may trade their external debt
bonds with the local commercial banks which at present hold the
bad-loans bonds. Since these long-term bonds are recognized as
instrument of payment in privatization, the Privatization Agency is
authorized to accept these bonds in exchange for parts of or the
entire enterprise. This process can be further facilitated when the
Government provides clear framework which will regulate the
operation of swapping external debt for portfolio investment in the
commercial banks which are to be privatized. Undoubtedly, there is
no threat for inflation or interest rate impact from the conversion
if these transactions directly lead to an exchange of debt for
equity, i.e. direct privatization.
In the case of issuing domestic bonds for financing the
transactions, very likely, with a high yield, there will be a jump
in interest rates, thus making the intertemporal government budget
constraint more stringent (see Dornbusch, 1987). The increased cost
of the public debt would involve decrease in the governmentвs
potential to finance its operations. As a debtor country
implementing IMF binding arrangements Bulgaria must carefully
monitor these impacts since they may result in noncompliance with
IMF liquidity criteria.
Furthermore, interest rates which are high enough in times of
restrictive monetary policy during transition will limit foreign
investors when the latter aim to expand their business. They are
looking for the cheapest way to finance investment and thus borrow
at lower rate in the international financial markets. This will
inevitably deter the development of liquid and large domestic
capital markets.
Some arguments may be put foreword for a fiscal burden that may
result from some preferential tax treatment of foreign investors'
business. Notwithstanding, that international experience suggest
that concessions do not necessarily stimulate foreign investment
the Government serious about attracting investment should be
cautious in giving fiscal incentives. Foreign investors' main
concern is with political and macroeconomic stability and long-term
profitability rather than preferences. Above all providing
preferences to foreign investment is possible only in terms of
clear privatization strategy.
External aspects
Debt-equity swaps have implications both for the flow and stock
of Bulgariaвs foreign assets and liabilities: they are closely
associated with the repatriation of flight capital and the creation
of new investment through the inflow of capital. DESs effectively
cancel external debt and relief interest payments on the converted
debt.
There are some arguments raised that exchanging debt for capital
brings to a debtor a counter-cyclical effect. DESs involves a
change in the composition of the debtor country's external
obligations since the transaction replaces interest payments by
profit remittances from return on investment. Profits are more
sensitive to the economic cycle and fluctuate according to the type
of the economic phase. In times of recession as is the transition
to market-based economy economic profits tend to fall. This way
after-tax profits of foreign companies are lower so the amount of
capital outflow is less than what would have been if interests ware
paid. This process contributes to the improvement of the net
capital position of the debtor country. The availability of net FDI
which is to be effected by a debt conversion programme will provide
for the short-run macroeconomic stability of the economy. On the
contrary, in a paper R. Davis claims that empirical data from
heavily indebted Latin American countries do not evidence such an
effect. Data which refer to FDI originating in US companies, show
that, after the 1981-2 shocks, FDI profits dropped considerably,
but remittances were stable even increasing in current dollars (see
R. Ffrench-Davis).
Franke argues the favourable evaluation of DES is not
well-founded and DESs can be expected to improve the situation if
they improve the situation as compared to the conventional method
of financing investment (Gunter Franke, 1992). In the present
analysis it is claimed that for Bulgaria as a troubled country DESs
will improve this investment process since the conversion schemes
change the quality of the debt and raise the country's
creditworthiness. DESs imply a change of the creditor -
multinational firms substitute international banks, and in this way
the quality of the debt is changed - project financing substitutes
of balance of payments deficit financing. This novel way of
post-deal methods of financing Bulgariaвs economy restructuring
will contribute to the overall management of the economy. From the
foreign investorвs point of view this improved quality of the
debtor country external obligations means a substitution of the
risk of nationalization for the default risk on debt servicing. A
control by the foreign investor is effected over the local asset
after the swap transaction. This new ownership guarantees efficient
management as opposed to the lack of monitoring over the use of
money borrowed from abroad.
Through the reduction of foreign indebtedness of the country
foreign investors reduce their exposure to risk and inward foreign
investments are streamed into the country. It is particularly
important for the present situation of Bulgariaвs economy , when
levels of domestic and foreign direct investment are insignificant.
All advantages that are subsequent from FDI - increased capital
formation, private sector development, utilization of country's
production and exporting capacity will improve foreign exchange
constrains and pick up employment as well as increase social
product. These effects amount to increases in liberalization and
privatization of state sector, as was the example with Mexico where
DESs were used in the privatization of around 520 SOEs.
The termination of the financial isolation which Bulgaria has
faced for a certain period of time will open an access of the
country to the international financial markets where foreign
financing can be obtained at some profitable terms. External
resources and foreign influence exerted by outstanding
international financial institutions help catalyzing policy
measures.
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